Interest Expense and Unlevered FCF, Explained
The question
Why is interest expense excluded from unlevered free cash flow, and where in the DCF is the cost of debt (including its tax benefit) actually captured?
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The answer
Interest expense is excluded because unlevered free cash flow is designed to be capital-structure-neutral. It measures cash available to all capital providers before any financing decisions, so subtracting interest would make the cash flow levered and break the pairing with WACC. The cost of debt, including its tax benefit, is captured entirely in the discount rate.
WACC uses the after-tax cost of debt, meaning we multiply the debt cost by one minus the tax rate, which implicitly gives credit for the interest tax shield. By taxing EBIT at the marginal rate in the numerator and applying the after-tax cost of debt in the denominator, we count that tax benefit exactly once. Deducting interest in the cash flows would double-count it.
The framework isolates operations in the cash flow and handles all financing effects through the discount rate, so interest stays out.
DCF timeline
| Line item | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Free cash flow | 50 | 54 | 58 | 63 | 68 |
| PV of free cash flow | 45 | 45 | 44 | 43 | 42 |
| Terminal value (Year 5 exit) | 1,001 |
| PV of terminal value | 621 |
| Implied enterprise value | 840 |
Also asked as
- Define unlevered free cash flow, write out the standard formula from EBIT, and explain in one sentence why each component is added or subtracted.
- A company's net working capital goes from $80M to $95M during the year. What is the impact on UFCF and why? What would a decrease from $80M to $70M do instead?
- If depreciation is added back to get UFCF, does a company's D&A level affect its DCF value at all? Explain the mechanism precisely.
- Walk me from net income to unlevered free cash flow, and explain why the interest add-back must be after-tax rather than the full expense.
- Your final explicit-forecast year shows revenue growth of 11%, EBIT margin up 150bps year-over-year, and CapEx at 2.2x D&A. What is wrong with applying a Gordon growth terminal value to this year, and how would you fix the model?
- How should stock-based compensation be treated in unlevered free cash flow? Give the defensible approaches and explain what combination of choices overstates value.
- Compute UFCF: EBIT $240M, tax rate 26%, D&A $55M, CapEx $70M, NWC rises from $150M to $166M, and deferred tax liabilities increase by $8M. Then state what single number changes if $30M of stock-based comp inside EBIT is added back, and what you must adjust elsewhere to keep the valuation honest.
- A subscription-software company collects annual contracts upfront, so working capital is deeply negative and becomes more negative as it grows. Walk through how ΔNWC behaves in the forecast, what happens to UFCF if growth suddenly decelerates from 25% to 5%, and why cash flow can deteriorate faster than earnings in that scenario.
- You're valuing a capex-heavy industrial that just completed a multi-year capacity expansion: last year CapEx was $500M against D&A of $180M, and tax depreciation is accelerated relative to book. Lay out how you would project CapEx, D&A, cash versus book taxes, and deferred taxes over a 7-year explicit period so that the terminal year is internally consistent, and identify which of these items must converge by the terminal year and why.
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Keep going
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- Explain why the cost of debt is tax-affected but the cost of equity is not.
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- Guide: the full IB Atlas guides library
The rest of this topic
The DCF: cash flow, discount rate, terminal value